5 Financial Bubbles: Are We Facing a Bubble of Bubbles?

We’ve heard a lot about bubbles in the economic world over the past decade – so much, in fact, that it seems like we might be facing a bubble of bubbles. But what does that mean to the average person? We’ll take a look at some of the issues and implications of our bubblicious culture this week and try to figure out how to handle it all.

What’s a Bubble?

The term bubble has been tossed around pretty liberally of late, with just about every asset class having been labeled a bubble at one time or another. All the while some analysts keep insisting that some of these bubbles are just bugaboos – symbols of success rather than excess. But what is a bubble?

Here are two different definitions from my old dictionary:

bubble: n. 1, a thin film of liquid holding gas or air. 2, an unsound project or idea.

So it seems that bubbles are structurally tenuous entities with nothing of substance at their core. How does that strike you? Do you think that accurately describes any part of our economy, financial system, or cultural zeitgeist? It’s been my contention that it very accurately describes all three. It seems to me that we’ve embarked on more than one “unsound project or idea” over the past few decades. As the opening quote hints, we can have long periods of economic advance that do not necessarily accompany any progress of substance for humanity.

The Bubble Roster – Part I

If our economy and our culture are essentially a bubble of bubbles, it seems like there should be a lot of them out there. Wednesday, we’ll take a look at some of the social trends that have been become bubbly. Today, we focus on some financial factors that have been stamped with the bubble moniker over the past few years:

5 Economic & Financial Bubbles

1. Real Estate: This seems like an easy one, as it would be pretty hard to argue that the U.S. residential real estate market was not in a bubble over the first half of this decade, given that it has already popped. Questions remain, however, about whether or not the U.S. commercial real estate market is the next real estate bubble to pop – or maybe it will be the Canadian housing market, or, heaven forbid, China’s.

2. Bonds: The bond market has been in a secular bull trend since the early 1980s, with U.S. Treasury prices rising and yields falling. At what point does a bull market become a bubble? Many have been calling for bond yields to rise for years now, and yet yields across various maturities continue to fall as worries about debt deflation mount.

Louise Yamada’s analysis seems to make the most sense out of any that I’ve read so far. She explains that secular bond cycles tend to last about 30 years. While bottoms (like the one in 1981) tend to reverse very quickly, tops (like the one we’re going through now?) tend to take 2 to 14 years to unfold. If that’s the case, we could be looking at lower bond yields for quite a while longer. In fact, Ms. Yamada points out that bond market tops are often associated with economic depression.

3. Commodities: Commodity prices might have been called a bubble before they got whacked (along with everything else) in the credit crisis. Since then, oil, agricultural commodities, and especially gold, have rebounded sharply. The argument for higher commodity prices often centres around emerging market (especially Chinese) demand. While I can see how that might be a long term driver of commodity price inflation, I tend to worry more that the popping of some of the other bubbles mentioned here (especially debt) will swamp commodity prices.

4. Stocks: Some stock bubbles are pretty obvious – like the NASDAQ bubble in 2000. Others are less so. Most won’t be identified as such until it’s too late and they’ve already popped. Are stocks in a bubble right now? Most people would say that stocks are neither grossly overvalued nor undervalued right now based on current earnings estimates. But if those estimates are wrong, all bets are off. If the other bubbles mentioned here start to pop, whether one at a time or all at once, those estimates will become meaningless. This is a time for caution and capital preservation.

5. Debt: Debt, both at the consumer and sovereign level, is probably the biggest, and possibly most dangerous, bubble of them all. Back in December of 2009 I identified debt as “one of the biggest factors in determining how the economy and markets perform in 2010“. So far we have experienced tremors in the credit and stock markets due to sovereign debt excesses in many European countries as well as deteriorating economic fundamentals. Unemployment remains elevated, making it difficult for already over-leveraged consumers to spend more – as if that’s always a good thing. U.S. sovereign debt levels are very close to hitting numbers that many consider dangerous.

Not only is debt a problem in and of itself, but it limits our options for fixing the structural problems we face. We have continued to dance to the Keynesian drumbeat, “solving” one crisis after another with ever-increasing doses of debt in a dangerous game of musical chairs. When will we find some leadership that’s willing to acknowledge that the music needs to stop? Shoveling debt on top of debt is not working. We need to put plans in place for the inevitable scarcity of chairs as we change the rhythm to one that everyone can dance to.

The Trouble with Bubbles

The trouble with bubbles is that they can continue to grow larger for longer than anyone expects. When they pop (and they always do), it usually comes as a surprise, sometimes even to those who have been predicting it for awhile. Whenever a bubble pops, the collateral damage is usually directly proportional to the age and size of the bubble. Everyone always thinks they will get out before the bubble pops, the music stops, or whatever metaphor you prefer. Few actually do.

If we stick with our earlier definition of a bubble as a structurally tenuous entity with nothing of substance at its core, then I would have to say that debt is at the core of our current financial bubbles. Growth built on debt is not real, especially when that debt is used to support corporate entities that are already insolvent. Debt can only lead to progress when used in moderation to support the real growth of viable businesses.

Given the bubble of bubbles that seems to be floating around right now, it seems like a relatively cautious position is prudent. Bubbles can pop very quickly, and often unexpectedly. Preventive measures and contingency plans are best made while bubbles are forming, and not while they’re popping. As I always tell my sons when they want to continue a potentially risky practice, just because it hasn’t happened yet, doesn’t mean it won’t.

What do you think about the bubbles mentioned here? Can you think of any others? How are you planning your finances and investments in light of this bubble of bubbles?

9 Responses to 5 Financial Bubbles: Are We Facing a Bubble of Bubbles?

>How are you planning your finances and investments in light of this bubble of bubbles?

1. Got out of the market entirely in late March 2010. We will likely see a deflationary cycle in the short term and serious stock market dip in next 12-18 months. Portfolio currently 60% cash / 40% 5 yr laddered GICs. When dips occurs (S&P 500 between 650-850), put 40% over 2-3 buys, in value dividend stocks that have international reach, hedging against drop in value of USD. Focus on countries with low debt-to-GDP ratios and companies with quality earnings at a low price to value. 2. Money printing will likely lead to increased monetary inflation in medium term, maybe 2-3 years, which will require to hedge against inflation with real return bonds, at around 15-20% of portfolio. Keep some cash for more opportunities. 3. Since we’re probably in for several years (4-7 years)of pain in stock market, as debt gets restructured/paid (e.g. bubbles bursting leading to deleveraging), we must then be patient for the next real rally in stocks after that period has passed. Emerging markets could be a good place to invest after the dip, with a watchful eye on a bubble there also.

Thanks for the great analysis and for sharing your strategy with us. It’s a good example of what an investing strategy actually looks like.

I pretty much agree with everything you said. The only thing I’m really not sure about is the timing of an inflation surge. I wonder if the U.S. will end up like Japan with deflation dragging on for a couple of decades, or whether the Fed will be able to produce inflation by printing money. Can anyone shed some light on that?

The trouble with bubbles is that they can continue to grow larger for longer than anyone expects. When they pop (and they always do), it usually comes as a surprise, sometimes even to those who have been predicting it for awhile.

This is so true. This is the element of bubbles that makes them so difficult. This is the very reason why I think it is difficult to time the market. What’s more important to us is what’s going on in our finances at the time we are making financial decisions (e.g. buying stock, real estate). Otherwise, we may be caught selling low or buying high.

It sure is difficult to time the market. But I’ve always contended that holding forever is just another form of timing. You may not sell low or buy high, but you could get stuck holding the bag in a secular bear market. It all depends on your time horizon.

Let me try a response to the deflation-inflation question. You are likely correct, a Japan-like deflation is here to stay for a while. Major quantitative easing (QE) from the US Fed (e.g. lots of cheap money to the US banks) did not lead to more lending as banks use that money to clean up their balance sheets, also profiting from free interest by buying US Govt bonds, and the fact that potential US borrowers either can’t borrow anymore (too much debt!) or are in a state of debt revulsion (same happened in Japan, more printing did not lead to more borrowing or “velocity”, even as rates are close to zero). In effect, printing money did not lead to inflation. So, Deflation – yes, for how long, nobody knows for sure, and no sign of inflation anywhere yet.

Most ‘experts’ (I am not an economist!) see the US borrowing binge as unsustainable: US trade deficit and housing boom will have to come down, and both US consumers and government will have to live within their means.

The scenario I put in my first post (deflation shortly followed by relatively higher inflation) is not the most dangerous, but a likely one ONLY if there is no crazy panic on sovereign debt, fragile US banks, on a major stock drop, a big war, etc. However, as the US owes more of its debt to foreigners (contra Japan, whose debt is held internally due to high savings of the Japanese people) there is potential that the US Dollar bubble will pop, if the US Government bond market implodes, due to lack of confidence from international bond buyers (or a need for interest hikes that could take 20-40% of US tax revenues in debt servicing).

Now, this could take 3 years, 7 years, 15 years, or never, nobody really knows, as a it depends on hidden financial factors (political secrets… remember Greece? off-balance sheet items like Afghanistan and unfunded liabilities such as US Social Security, Medicare, etc.) and market psychology… but IF it does happen, then hyperinflation will set in as people will have lost confidence in their currency and US consumers may still have to buy goods from other countries, when everybody has lost confidence in the US Dollar. Ok, nightmare scenario, but I suggest you take a look at this video presentation by Niall Ferguson:

Conclusion: what will that do to the Canadian economy? We should be spared by hyperinflation and our money will likely be perceived as sound (paper money is about confidence and perception), and we will likely see a rise in interests. But, a question: what happens when you don’t trust the money that your major customer uses to pay you? Answer: you don’t sell! And when you don’t sell, you don’t make any profit…

Thanks Bruno. That’s one of the clearest explanations of the possibility of Japanese-style deflation in North America that I’ve read. I’m not an economist either. I just use Balance Junkie as a way to think out loud and learn something new from readers like you. Thanks for reading and thanks for helping me clear up some of my thoughts!

Really liked this post. The first commenter’s reactions to what he thinks is coming were also interesting. One thing I’d add as a word of caution: it’s possible to be exactly right about where the next bubble will be, but exactly wrong about how to profit from it. Peter Schiff pretty famously predicted the financial crisis but lost his clients a lot of money.

Correct. The strategy has to be tailored to protect the portfolio in both cases (deflation-inflation). The object is not to beat the market but to provide returns through proper diversification with low amount of risk. Trying to time this thing is not a good idea, but some understanding the the macroeconomics is a good idea. I try to stay away from stocks and long term bonds right now as they are too risky in the short term while ensuring some returns through GICs and potentially real return bonds in the future. For stocks, better to buy low than high and right now they are somewhat pricey anyway.

Good point Pop. I happened to be right on the crisis of 2007-2009, but I didn’t make any money on my prediction. Mind you, I didn’t lose any money in the downturn either, so that’s OK by me. I guess it’s possible to predict a bubble, but much harder to know when it will pop and how and when various markets will react.

My main points at BJ are that 1) We are in a period of elevated uncertainty with lots of imbalances in our economy. 2) Reducing risk in your personal finances and your portfolio according to your time horizon are a prudent course of action until we see how these imbalances correct themselves.